Question

According to the Bank of Jamaica in a statement on its monetary policy, “Under the Bank of
Jamaica Act (1960), the conduct of monetary policy is aimed at regulating the growth of money
and credit in line with the resources expected to finance economic activity and generate
employment, without undermining the conditions of price stability”.
The recent COVID19 situation has resulted in many persons being unable to work and has led to
a decrease in economic activity in Jamaica.
a. With the aid of a diagram, show the effect of this decrease in economic activity in the
money market. Make sure to label your graph.
b. On the same diagram in part (a), show what should be the reaction of the Bank of
Jamaica in this situation.
c. Discuss two instruments of monetary policy that may be used by the Bank of Jamaica to
achieve its goal in part (b).
d. What should the Bank of Jamaica keep in mind about business fixed investment as it
reacts in part (b) in light of the current economic situation? Make sure to explain how
the reaction of the Bank of Jamaica that you suggested in part (b) may affect business
fixed investment.

Answer 1

Answer a). Monetary policy is defined as the changes in the supply of money and credit. It refers to the policy measures undertaken by the government or the central bank to influence the availability, cost and use of money and credit with the help of monetary techniques to achieve specific objectives.

The economists regard monetary policy is the macroeconomic policy laid down by the central bank. It involves management of money supply and interest rate and is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity.

Monetary policy aims at influencing the economic activity in the economy mainly through two variables

1. Money or credit supply

2. The rate of interest.

The Central bank reserve uses monetary policy to manage economic growth, unemployment, and inflation. It does this to influence production, prices, demand, and employment. Expansionary monetary policy increases the growth of the economy, while contractionary policy slows economic growth.

The basic three objectives of monetary policy are controlling inflation, managing employment levels, and maintaining long term interest rates.

Since, the economists feel that monetary policy should work hand-in-glove with the national government's fiscal policy, but it rarely works. Government leaders get re-elected for reducing taxes or increasing spending. As a result, they adopt an expansionary fiscal policy. To avoid inflation in this situation, the Fed is forced to use a restrictive monetary policy which is prevalent in 2020 also during the COVID-19 pandemic. Hence it involves the management of money and credit for the furtherance of the general economic policy of the government to achieve the predetermined objectives. There have been varying objectives of monetary policy in different countries in different times and in different economic conditions.

For example, after the Great Recession, Republicans in Congress became concerned about the U.S. debt. It exceeded the debt-to-GDP ratio of 100%.7 As a result, fiscal policy became contractionary just when it needed to be expansionary. To compensate, the Fed injected massive amounts of money into the economy with quantitative easing.

Looking at the current situation of COVID-19 in 2020 we can draft the role of monetary policy with an impact on decreasing economic activity with an example as

The economy is suffering a recession and high unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP. So, the short-run upward-sloping Keynesian aggregate supply curve (SRAS). The original equilibrium during a recession of E0 occurs at an output level of 600. An expansionary monetary policy will reduce interest rates and stimulate investment and consumption spending, causing the original aggregate demand curve (AD0) to shift right to AD1, so that the new equilibrium (E1) occurs at the potential GDP level of 700 as shown in the figure-

Expansionary and Contractionary Monetary Policy-

Graph -1

Graph-2

The economy is originally in a recession with the equilibrium output and price level shown at E0. Expansionary monetary policy will reduce interest rates and shift aggregate demand to the right from AD0 to AD1, leading to the new equilibrium (E1) at the potential GDP level of output with a relatively small rise in the price level. (b) The economy is originally producing above the potential GDP level of output at the equilibrium E0 and is experiencing pressures for an inflationary rise in the price level.

Whereas Contractionary monetary policy will shift aggregate demand to the left from AD0 to AD1, thus leading to a new equilibrium (E1) at the potential GDP level of output.

A contractionary monetary policy will raise interest rates, discourage borrowing for investment and consumption spending, and cause the original demand curve (AD0) to shift left to AD1, so that the new equilibrium (E1) occurs at the potential GDP level of 700.

Answer b). In current COVID-19 impact the Bank of Jamaica can influence interest rates by changing the discount rate. The discount rate (base rate) is an interest rate charged by a central bank to banks for short-term loans. For example, if a bank of Jamaica increases the discount rate, the cost of borrowing for the banks increases. Subsequently, the banks will increase the interest rate they charge their customers. Thus, the cost of borrowing in the economy will increase, and the money supply will decrease. Henceforth, in case of expansionary monetary policy the bank of Jamaica will cause the supply of money and loanable funds to increase, which lowers the interest rate, stimulating additional borrowing for investment and consumption, and shifting aggregate demand right. The result is a higher price level and, at least in the short run, higher real GDP whereas in contractionary monetary policy, the Bank of Jamaica will cause the supply of money and credit in the economy to decrease, which raises the interest rate, discouraging borrowing for investment and consumption, and shifting aggregate demand left. The result is a lower price level and, at least in the short run, lower real GDP.

Answer c). Considering the current COVID impact Bank of Jamaica in continuation to answer b with respect to actions of Bank of Jamaica it can be further concluded that as central banks in most of the economies set up the minimum amount of reserves that is must to be held by a commercial bank. Hence by changing the required amount, the bank of Jamaica can influence the money supply in the economy. Further if monetary authorities increase the required reserve amount, commercial banks find less money available to lend to their clients and thus, money supply decreases. The commercial banks can’t use the reserves to make loans or fund investments into new businesses. Since it constitutes a lost opportunity for the commercial banks, central banks pay them interest on the reserves. The interest is known as IOR or IORR (interest on reserves or interest on required reserves).